The Wondering Mind

A while ago, the Insurance Institute for Highway Safety, (IIHS) published videos and results from crash tests they conducted using some compact cars crashing into mid-sized ones. The results appeared alarming, with the smaller vehicles apparently not fairly all that well. The upshot, as far as IIHS was concerned, was that small cars are bad for safety.

Well, that’s one, very simplistic interpretation. A conclusion laden with a barely hidden bias.

To begin with, the clear implication the IIHS is spreading is that small cars are just inherently unsafe. Period. If you pushed them on it, they would almost certainly deny that that is what they are saying, or even implying, but it is. And the reason they would deny it is because it’s not true.

The Smart car, as well as the Yaris, have been sold in Europe and other parts of the world for years before coming to the U.S. and they have a safety record that is generally no worse than other vehicles. And all three vehicles have performed well in most, if not all, standardised crash tests until the IIHS’s newly concocted demonstration. That doesn’t mean that they are the safest vehicles, or that they couldn’t be safer, but inherently unsafe they are not.

Are they likely to be less safe places to be in a crash against a hulking truck, than in the hulking truck? Yes. And the IIHS is correct in saying that is a simple matter of physics. The smaller vehicle, and its occupants, having less mass in the collision, will decelerate at a much faster rate (or even be pushed back). That means that the occupants of the smaller vehicle will experience more force in the impact. The smaller dimensions of the vehicle also mean there is less material and leeway for the force of the impact to be absorbed and dissipated by the vehicle structure.

The problem is the IIHS conclusion and recommendation, which is not the only possible response to such a dilemma, and displays a clear bias. It also arguably imposes much greater social costs than the alternatives.

The IIHS recommend that we keep larger vehicles, but spend more money on making them more fuel efficient. (They seem to ignore the irony in that larger vehicles will never be as efficient as smaller vehicles, as a matter of simple physics. I guess calling on physics wasn’t quite so convenient in this case.) So their solution is to keep “unsafe” smaller vehicles off the road.

But what about taking dangerous larger vehicles off the road instead?

As the second WSJ article cited points out, the “danger” of the smaller vehicles is primarily in the disparity of the size of vehicles on the road today. One way to reduce that is to take the larger ones off the road.

You can do that by discouraging the sale of new larger vehicles and encouraging the disposal of existing larger vehicles. You can do the former simply by raising fuel prices, or an even more sensible way would be to impose a carbon tax. This means that manufacturers can certainly make their vehicles more efficient by producing larger hybrids or diesel vehicles, and you leave the consumers the choice of purchasing such vehicles. But, it will always be cheaper to buy smaller vehicles. (That damned physics again.)

This would also have the effect of encouraging people to junk older, heavier (and larger) vehicles because it would be too expensive to run. The government could even add an extra incentive for junking those vehicles. (This would probably be most effectively, and most efficiently, used for providing an incentive for poorer owners of older vehicles, for whom the purchase price of newer and more efficient vehicles might be an insurmountable hurdle otherwise.)

As suggested by Mr. Wenzel in the article, the government could provide a certain amount of relief for people who really do need to use the larger vehicles for work, as opposed to just posing. Although, to be fair, any such subsidies should be put in place to be phased out over time. How is that fair, especially on businesses? Externalities.

Externalities are also the reason why its in some ways more “fair” to take the larger vehicles off the road. It’s the larger vehicles, or rather their drivers, who are imposing a cost on other people by their preference for larger vehicles. Drivers of smaller vehicles are only in more danger because the drivers of larger vehicles pose that danger. It seems to make sense to me to eliminate that externality by encouraging people not to drive larger vehicles.

Now there are businesses which do need larger vehicles to haul cargo, or people, or whatever. And in making an initial transition, it makes good policy sense for the government to ease the burden of change, both to encourage, and so that businesses can make the change. (It’s like helping the poor car owner; businesses might not be able to afford the new vehicles otherwise.)

After the transition, however, it doesn’t make sense for a continued subsidy. Fact of the matter is, even if the larger vehicles are necessary, they still continue to impose external costs on other drivers. So why shouldn’t they pay for that cost through higher prices? Will the businesses pass on those costs of consumers? Absolutely! But there’s no reason consumers who benefit from those businesses should not have to pay also for the external costs imposed on society for their consumption.

Such a policy will also have the benefit of encouraging manufacturer to work on more efficient larger vehicles, as long as they are cost effective, and encouraging businesses to buy smaller, more efficient, vehicles as they can use. I often wonder how many businesses really need the Titan V8 truck, as opposed to the smaller V6 version.

It’s not hard to imagine that this model of vehicle safety would ultimately be less costly to society than the one IIHS is pushing on us.

One thing you learn to do when you learn economics is to think of a problem in terms of incentives. Not always easy, but I think I have a very clear and good example. The piracy problem off the coast of Somalia. This is something that has been in the news much this past week due to the U.S. crew on cargo ship which was attacked. Thankfully, all crews are now free and safe.

The piracy problem, however, is far from resolved and only seems to be getting worse by the day. And when one looks past a lot of rhetoric and bluster, it’s clear that no one has an answer to this problem.

On a BBC News web page soliciting public opinion, there appear to be broadly 3 types of actions being suggested. (I am not counting a lot of the political finger-pointing, which is not all that helpful.)

1. Punitive collective punishment, against all the pirates, the various villages they come from, or the whole damned country. A less violent (and legal) version of this is for forceful response to piracy.
2. Use of escort convoys. People make comparisons to WWII, but this is something that is actually being done now with some, if not all, shipments of food aid to Somalia.
3. Arming the merchant ships and sailors.

(There are also some other useful suggestions at the very end of the article here.)

What all these suggestions seem to have in common is that fact that they seem to have resulted from a complete lack of any thought on the incentives and disincentives at work on the various parties.

So let us look at each party one at a time and see what incentives and disincentives they have.

First, the pirates.  The incentives are obvious. According to one report on the BBC, one pirate claims to have netted $250,000 from just one incident. You don’t have to live in Somalia for that to be exceptional pay for a day’s work. The disincentives are that it is dangerous work. Just look at what happened to three of the pirates holding the U.S. captain hostage.

Unfortunately, this is not that much of a disincentive. Those cases where the pirates are captured, less actually come to harm, are rare. And for pirates who are captured, it is not at all clear what you can do with them. Somalia has no functioning government, less an effective judicial system. No country wants to start bringing Somalis to their own country to prosecute. Some have tried dumping them on Kenya, but no one actually knows how effective a deterrent that has been, or if the Kenyans are even equipped to prosecute pirates seized by other countries.

What we have just looked at are absolute incentives and disincentives. There are also comparative incentives and disincentives. How does piracy compare against alternatives for these people?

In terms of incentives, it compares very well, since there are very few, if any, alternative means of income for many of these people. If there are no alternatives, it doesn’t really matter what you think or feel about piracy.

The disincentives compare favourably also. Living in Somalia is hard and dangerous by any standards. The main difference between engaging in piracy and not seems to be that most people try to avoid the dangers of Somali life, whereas you are seeking a higher level of danger by pursuing piracy. Unfortunately, piracy has a huge potential payoff, the other option does not. And besides, there’s no getting away from the hardships of Somali life short of leaving the country.

When seen in this light, the suggestions for action don’t have much merit. Action against Somalia will not work, unless you are intent on wiping out the entire population (I think they call that genocide), or you want to occupy the country and rebuild it.

Convoys are hugely expensive and, for that reason, untenable.  The pirates can just wait it out, until the navies get sick of escorting convoys, and then start again.

Arming merchant ships is not very practical. The pirates can, and will, always out-gun any armed merchant vessel. The only certain result of such policy will be increased danger and fatality, mostly for the merchant crew. Remember, the pirates’ lives are already pretty miserable and dangerous; how much worse will armed merchant ships make things for them?

What everyone seems to be missing in all this is that they are intent on setting up punitive deterrents. Clearly that won’t work. If punishment as deterrent worked all the time, we wouldn’t have any crime. So how about taking away the incentives for the pirates?

One, admittedly very simplistic, suggestion would be to make it illegal (maybe even criminal) to pay ransoms. This would be somewhat different from the classic “kidnap for ransom” scenario in that the party capable of paying the ransom is disinterested. While a rich person might pay a ransom for a family member even if it was against the law, a business would not, at least not without risking going out of business.

Businesses would then be faced with a choice. They can risk piracy by taking the same routes, assuming that they can find people to crew the ships. If a ship is taken by a pirate, the company can either pay up and face being prosecuted out of business, or not pay and face ruin in the court of public opinion. Or, they can reroute their ships to stay clear of pirates.

As people have already observed, rerouting ships is costly. But so is paying ransoms, and the various navies who protect ships don’t come free.

Under such a scenario, the payoff from piracy may decrease sufficiently that there is no longer enough incentive to keep doing it. The problem is in the details of such a plan.

This will take collective action on the part of many governments to enact, and properly enforce, the anti-ransom laws. Piracy will not be discouraged as long as there are ships to loot from countries with no such policy. And enforcement will also be problematic. There will be those sympathetic to companies paying ransom to save lives (while conveniently forgetting that it was those companies who put those lives deliberately in harms way in the first place).

The point isn’t that I think I have some great solution. The point is that public debate doesn’t seem to be considering all the incentives at work in shaping our current situation.

I used to find Frank Rich’s columns a bit too ranty for my tastes. So it worries me that I seem to find them more and more reasonable and in agreement with my own views. Either Rich is getting “better” in his columns, or I’m starting to lose it. Probably a bit of both.

So I was a little cheered to read his latest column and find that I didn’t agree with everything he said. I generally agreed with the bits which were for tarring and feathering the CEO-class. It was this little bit of aside in the middle of the piece I didn’t agree with. The question he asks us, and himself, is,

But even as that unanswered question hangs in the air, a more revealing inquiry might be this: Why is there any sympathy whatsoever for a Detroit C.E.O. who helped wreck his company, ruined investors and cost thousands of hard-working underlings their jobs, when there is no mercy for those who did the same on Wall Street? Might we, too, have a double standard? Could we still be in denial of the reality that greed and irresponsibility were not an exclusive Wall Street franchise during our national bender?

The answer he suggest is “yes”.

Perhaps we’re tempted to give Detroit a pass because it still summons nostalgic memories of “American Graffiti,” “Little Deuce Coupe” and certain things we used to do in the back seat of a Chevy. Wall Street and bankers are the un-aphrodisiac: “Bonfire of the Vanities,” Old Man Potter of “It’s a Wonderful Life” and, of course, Gordon Gekko of Oliver Stone’s “Wall Street.”

Though Gekko’s most famous line is “Greed is good,” even more emblematic is his defiant summation of his brand of capitalism: “I create nothing. I own.” At least Wagoner, unlike the sultans of finance, created cars, clunkers though they often were. The politically conservative Nashville star John Rich draws this moral distinction in his powerful new hit single “Shuttin’ Detroit Down.” Motor City is “the real world,” he sings, unlike those big shots “living it up on Wall Street in that New York City town.”

I’m not sure that’s entirely correct. I’m sure there is a certain level of class-ism in a country which loves to see itself as classless (a self-delusion which has always made for good PR, not so much as penetrating political and social analysis). This is helped quite a bit by the fact that GM and Chrysler factory workers did not get into their careers to get rich by not giving a damn about anyone else but themselves. (Well, they might have, but in that case they are very stupid and made a very poor choice of careers.) I think any apparent “sympathy” for Rick Wagoner et al. is only collateral sympathy which is held for the workers. (Firing Wagoner is not a vote of confidence for GM, which is bad for the GM workers.)

No matter how much the banking cabal bleat on about their their (non-existent) innocence and decency, most sane people recognise that anyone who thinks they deserve, because they own, so much more than others who work is possessed of gargantuan arrogance and some level of misanthropy. To varying degrees, these are people who are culpable in any sticky end they come to, and they got very (in some cases obscenely) rich in the process. Why do they need, never mind deserve, our sympathies?

And yes, there are and were plenty of people in finance who did not get rich who essentially got done in by “friendly fire”, but in most cases these people did not fail to get rich for want of trying. I’m not sure you deserve sympathy when you wanted to be one of the “masters of the universe”, but never got there because you just weren’t good enough.

Personally, I don’t think GM should be bailed out. Not because I don’t have sympathy for the workers. I do, and I think the government needs to do much more for them, and for the millions of others who have been made redundant. But the size of the failing business should not justify propping up a company which would be allowed to fail if it was only smaller and less politically sensitive.

But by the same token, I think the government should have, and should now be, scything through the ranks of the finance sector. (I refuse to call finance an “industry”. That’s just insulting for people who do actually work in industry.) They should be allowing many, many more financial institutions to fail and firing a lot more “executives”.

The failure to root out the cancer that these institutions and individuals represent to the rest of society has huge costs, both financial and social. The insistence on trying to repair a rotten system speaks volumes of the lack of imagination and courage on the part of the people involved. (We can start with Larry Summers and Geithner, but it’s a long list.)

More to the point, it won’t work. Even before the current crisis is over, news papers are writing about how executive pay is still not seriously curtailed, or the fact that many expect any reversal in fortunes to be temporary at best. (Not really surprising when you think of the sorts of “heroes” who make up the highly paid boards at many companies.)

And it’s this double-standard the people are railing against. Between those who are at the top who don’t think they should be held accountable for anything, and the rest of us who are always held accountable for everything. Wall Streets is in the cross-hairs more than Detroit because the hypocrisy is on a larger scale and so much more obvious.

The on-going saga at AIG is a drama in the ridiculous, the outrageous, and (for the taxpayers) the tragic. The public outrage that came about from the news of the “retention” bonuses did not have long on the news cycle before the media outlets and the Obama administration started a concerted campaign to convince us that it was over the top and misdirected, so that the masses would not get in the way of the continuing bailout.

I’ve blogged before about why I don’t believe the public anger is misplaced or over the top. I’ve also written about what many believe is an arrogant sense of entitlement among these Wall Street types.

Well, just to  make my point for me even more clearly, this idiot wrote an op-ed in the NY Times. You can read some of the reasons why at least one of my friends hoped the author would get hit by a bus.

The letter is so outrageously self-righteous, self-satisfied, and self-entitled, that it literally took my breath away. I also could not believe someone would be quite so stupid as to publicise the biggest “kick me” sign on his back I have ever seen.

The amazing thing is that this fool is not alone. Just read here and here for more whining from the gilded set.

It’s not surprising that these people may feel put-upon. And that, seen in isolation, their treatment in the last year or so by various parties has been harsh, if not outright unfair. But they can’t be that stupid.

You can’t see the treatment of these people in isolation from what they did for years. The anonymous author of the supposed letter from within AIG rightly holds the system and the politicians responsible. But there is absolutely no recognition of the fact that he/she, and others like them at AIG, played within that system. Played by that system’s rules, played with the politicians, for profit which was completely dissociated from any benefit they may have conferred on society at large. If you participate in what you yourself describe as a corrupt system, why would be expect a happy ending for yourself?

There is also a complete lack of solidarity with the millions of others who have been victims of the financial crisis. They too worked hard and they had even less, if any, involvement with creating, running, and perpetuating the system which caused the current crisis. And yet they find themselves in straits even more dire than many at AIG. Why are those at AIG owed more than the rest of us?

You really have to look to the Middle Ages, or the Dark Ages, for this sort of sense of entitlement. When people were taught that kings and lords were somehow entitled because God must have ordained it. Maybe DeSantis and others believe that God ordained their bonuses.

For the rest of us who don’t believe that kind of rubbish, we need to let our politicians know that it is now beyond time they threw out the corrupt system of finance and the crooked actors who have profited from it once and for all. If they want to put a failed system on life-support with our hard-earned money so that this self-appointed new class of gentry can live in $10,000 a month flats, then we need new politicians.

I was given links by a friend showing pictorial depictions of the current Armageddon we are calling a recession.

The first struck up a more optimistic note, pointing out that compared to the Great Depression all the statistics show a much less apocalyptic trend. I think it is useful for reminding us to keep things in perspective, and not to panic. That’s not a bad advice in the current climate.

It also illustrates a key weakness of many economists; this is no consolation to the millions of people who have lost their jobs. Their loss is only compounded by the fact that while the recession may not be as dire as it was in the 1920’s and 1930’s, it is still bad enough there is a distinct shortage of jobs. That means those who have and who do lose their jobs now are probably in for a long period of hardship and unemployment. The fact that there is not as high a proportion of people in such a predicament is hardly a consolation to anyone.

The second article illustrates this point. If you look at the interactive map, you will see that almost no area of the country has been spared. 

We can only hope that reminders such as this one of the human loss, a loss shared by the entire country, might spur the business leaders and politicians to behave better than they have.

I doubt it, but we can hope.

What speaks volumes about why people are so angry right now is Jamie Dimon, the CEO of JP Morgan, in this article.

You could make a case for why the business is better off with these jets. About why it might actually be more efficient and cheaper for them to use these jets rather than having to tackle the gauntlet that is the modern commercial travel.

Instead, you get a breathtaking sense of entitlement and arrogance. A condescending dismissal of those who have a hard time reconciling the luxury of private jets and hangars at a time people are losing their homes.

You might think these “masters of the universe” believe that what is good for them is good for the country, a rather ironic paraphrase of the GM saying. But you’d be wrong. These people believe they are the country. The rest of us are a burden on their gilded lives.

And then these people wonder why the mobs want to string them up in the streets.

Well pretty much everyone not in cryogenic stasis has heard of the farce at AIG by now. There are so many things I want to shout about this, I barely know where to begin. So I thought I would rant about one thing that bothered me about this from the start. And it’s the idea that AIG needed to offer retention bonuses to these people.

Really?

We are now in an economy where talented people are getting laid off all over the place. It is far from clear for anyone except the politicians and the bankers, including the ones at Treasury, why we couldn’t get equally “competent” people without any incentive beyond something called a “paycheck”.

If we really, really need to hold onto the existing employees, as Liddy and Geithner have claimed, I still see no reason for a bonus. These are the scumbag idiots who brought down AIG; who the hell is going to hire these toxic bankers? Anyone fool enough to hire these clowns, well, you’re welcome to them. Unless it’s a bank with government TARP money, in which case the government should promptly close that bank down.

The whole idea of incentive pay like retention bonuses and golden parachutes, etc. have never made any sense to me. The whole premise for such schemes were so transparently fraudulent it’s a disgrace that supposedly intelligent and ethical adults buy that rubbish, especially at a time like this.

The people at AIG were either fools who did not know what they were doing, or they were reckless and arrogant in their self-esteem. If the former, no one will hire them. If the latter, Wall Street will probably welcome them with open arms. But in the current climate, it is hard to see what other employer will have an opening for them. They’re busy laying off their own bankers; why would they hire ones so tainted?

Similar slight of hand has been used by bankers, executives, and the like arguing for their bonuses in the past. “If you don’t pay, they’ll go some where else.” But where?

“Oh well, China would hire them.” Or “Dubai or Singapore would love these guys.” Really?

If you’re some Anglo-Saxon in your 40’s, or so, then there is a high transaction costs involved with going to China, Dubai, or Singapore because they will pay that much. (And it’s never clear that such high pay is available abroad.) Your family who may not want to move to some place with no family or friends, for a start.

There’s a price to pay for living in places where the air quality is so bad scientists believe it shortens your life expectancy, or living in a place where you are fined for chewing gum.

And then there’s the cost of the move, there and back. Not only the financial costs involved, but also the disruption to life, the adjustments needed, etc. I’ve lived in several countries and many more cities, so I can say from experience that it is not an easy adjustment, especially moving to a place where they speak another language.

There are some people who love that kind of stuff, but most people don’t. And even among people who do like it, they like it much less as they grow older and have more ties and commitments.

So why do so many companies apparently buy this fairy tale? Because the people who are in charge have a stake in the game themselves. They are the same coterie who populate all the boards of each other’s companies. Or they’re “HR consultants” who are hired by the very people whose pay they advise on.

Which is why it is so sad to see the Obama administration toe the line on this. For an administration which is supposed to break away from the cronyism of the Bush era, they seem far too ready to buy into the established traditions of corruption.

This is the primary danger for the administration. It is not so much that they are squandering goodwill, although they are. It is that the people will lose faith in the idea of change. When you pass up such obvious opportunities for much needed change, people are going to wonder if you have the competence or the will to make truly meaningful change.

There is a desperate need for change in health care and education, to name only two areas. And these changes will require painful compromises and sacrifices. They will also be opposed by powerful vested interests. The only way these changes happen will be with the broad and unstinting support of the people. But you will not have such support if the people doubt your competence or your motives.

Among the latest articles chronicling the end of the financial world as we know it, there was an article detailing some of the difficulties now faced by state universities in the U.S. 

It’s pretty much run of the mill for this kind of story, and we’ll be hearing more about it again, I am quite sure. What I do think bears more discussion is the content of the following passage.

Mr. Crow’s record for improving quality is impressive, too. He has hired more than 600 tenured or tenure-track faculty members, and last year, for the first time, won a spot on the National Science Foundation’s list of the top 20 research universities without a medical school, along with powerhouses like M.I.T. and the University of California, Berkeley.

But not every university can be in the top 20. And in a time of shrinking state budgets, undergraduates at public universities will most likely pay the price in higher tuition, larger classes and less interaction with tenured professors. So it is a real question how many public research universities the nation can afford, and what share of resources should go to less expensive forms of education, like community colleges.

The first point to make is that as the article mentions later on, being a cutting-edge research university is not the same thing as being an excellent teaching school for undergraduate students. Most of us know that just because you’re a genius who understands all the ins-and-outs of a particular subject does not make you the best teacher of that subject.

Mr. Crow’s objective of creating an institution which excels both in research and teaching is a fine one and those objectives do not necessarily conflict with each other. Those objectives are not, however, the same. More importantly, in an environment with limited resources, directing resources toward one objective means less resources available for the other objective.

While it may be unpalatable, universities and policy makers should acknowledge that these different objectives are coupled through choice, not because they are inseparable.

Which brings me onto my second point: not everyone can be number one.

In fact, the idea that every state can have a leading research university is simply a non-starter. As the article points out, simple arithmetic dictates that to be a “leading” research university in such a scenario means being in something like the top 20 such institutions. But if every state had such ambitions, then the majority will be bitterly disappointed. And all the states are likely to spend increasing amounts of money chasing their ambitions, most for little to no reward.

This observation extends to teaching as well. With hundreds (I think) of tertiary teaching institutions in this country, only 20 schools can be in the “top 20″ for anything, including teaching. Rankings are only a useful metric in so far as they tell us something about the difference in quality.

First, they should tell us that there is an ordinal difference in quality. That is, there should be a measurable superiority in quality in the school ranked number one versus the second ranked school. As many, many people opine, this is rarely the case, with most rankings being criticised on this very point.

Second, rankings imply a certain degree of cardinality in the difference in quality. For example, as a student, you would much prefer going to a top 20 school than the one ranked 100th, and there is much more prestige associated with the top 20 than the top 100. But a top 20 school may not be significantly better than a top 100 school.

Ultimately, it is probably more important that a school achieve a certain threshold of excellence rather than worry about how it compares in ranking. In a cash-strapped environment, this is especially important since the additional resources necessary to improve in rankings will likely experience severe diminishing of returns.

All things the taxpayers, if not the policians, will care about in the current environment.

Every time we have some minor, or major, financial economic meltdown, accountants seem to be involved. With Enron, it was Arthur Andersen. In the Madoff scandal, we find that the multi-billion dollar scheme was audited by a two-person outfit, and nobody thought that odd. Now there is report that one of India’s major corporations has been struck by fraud.

First of all, it demonstrates the pathetic lack of oversight by just about any and every “regulator” of any consequence out there.

In addition to India, Satyam has been listed on the New York Stock Exchange since 2001, and on Euronext since January of 2008.

You would think that at least one of the countless regulators overseeing the three exchanged would have done its job, but no.

But what I really want to vent on is the auditors.

The company has been audited by PricewaterhouseCoopers since its listing on the New York Stock exchange.

And how badly did PwC do their job?

Mr. Raju said Wednesday that 50.4 billion rupees, or $1.04 billion, of the 53.6 billion rupees in cash and bank loans the company listed as assets for its second quarter, which ended in September, were nonexistent.

Revenue for the quarter was 20 percent lower than the 27 billion rupees reported, and the company’s operating margin was a fraction of what it declared, he said Wednesday in a letter to directors that was distributed by the Bombay Stock Exchange.

Let me expand on that with a quote from another article.

The Indian affiliate of PricewaterhouseCoopers was the company’s auditor. It appears to have certified the company had $1.1 billion in cash when the real number was $78 million.

In other words, PwC thought the company had 14 times the cash they actually had. Or to put it yet another way, the company actually had just $0.07 for every dollar they claimed to have.

As a former auditor, I know that it can be extremely difficult to uncover a fraud being perpetrated at the highest levels of management. They have a great deal of control over the company and its operations, as well as having the ability and opportunity to recruit collaborators, through inducements or pressure. But it’s hard to see how how you mistake $78 million for $1.1 billion without someone at PwC not doing their job.

Thing is, anyone who has worked in public accounting can tell you exactly how something like this could have happened. I might have ranted about it in previous posts, so I won’t detail them here. But the fact of the matter is that many, if not most, large audit accounts (as well as the smaller ones) are performed in a manner that just begs fraud and malfeasance to go undetected. Most auditors know, if they’re truly being honest with themselves, that something like this could easily happen to them on any number of clients, but for the Grace of God.

Just as many sensible people are calling for the reform of the ratings systems, where agencies like Moody’s and S&P are paid by the bond issuers, regulatory agencies need to seriously consider changing the entire system of “independent” audits. How independent is an audit when the management of companies pick their own auditors and pay them to tell the public that their books are straight? How successful in business do you think will be the auditor that keeps finding problems with clients’ accounts?

The current system of regulations is designed to regulate on the cheap. And like most cheap things, it only works when the planets are perfectly aligned and it has wind behind its back. In this particular case, auditors only ever catch mistakes, rarely frauds or other criminal acts. And they often miss the mistakes too.

If regulators were serious about audits, they would make auditors agents of the regulators and send them in with investigative powers, backed by powers of criminal sanction. Sure, that system would be onerous. And it would be expensive. But here’s the thing:

You have enough Enrons, Madoffs, and Satyams, and even the slowest person will realise that investors have no real protection in the market. At some point, their fear of being ripped off will outweigh their greed. And then the companies will be praying that they can entice investors back into the market with just the measures I’ve mentioned.

More likely, they will have to accept even more draconian measures at that point to attract investors, and then only the very few and the very best companies will be able to attract money. And as every good capitalist should know, that isn’t good for the market, the economy, or society at large.

P.S. – If you’re still not convinced, I present my final exhibit for the prosecution. This kind of fraud can be extraordinarily hard for audits to uncover. But then an audit, as it stands today, doesn’t seem to have too much utility now, does it?